Defining The Best Order In Which To Pay Off Your Debts First?

If you find yourself burdened with debt on multiple credit cards or loans, rest assured that you are not alone. According to a 2021 Experian report, the average American with credit cards carries a debt of $5,525. It’s important to note that this figure doesn’t even include other common debts such as mortgages, car loans, and student debt.

While it’s crucial to make at least the minimum monthly payment on each debt you owe, determining how to prioritize any additional funds for debt repayment can be a challenging task. Merely making small monthly payments on all of your debts can result in higher interest payments over a prolonged period. To effectively tackle your debts, it’s advisable to focus on certain debts over others. Once you have chosen a debt repayment strategy, the key to achieving a debt-free life lies in maintaining consistency and discipline.

Pay off the highest-interest debt first

Advantages: One of the primary benefits is the opportunity to save money and allocate funds towards other financial objectives.

Drawbacks: However, if your largest debt carries the highest interest rate, it may require a considerable amount of time to fully repay it. This factor can potentially demotivate individuals and increase the chances of abandoning the chosen strategy.

Ideal for: This approach is particularly beneficial for minimizing the total interest paid over time.

It is highly advantageous to prioritize the repayment of your highest-interest debt for a valid reason—it is the debt that is costing you the most. Debts with above-average Annual Percentage Rates (APRs), particularly credit card debts, can prove to be exceptionally challenging to eliminate. Anyone who has dealt with student loans or mortgages understands the frustration of monthly payments that primarily cover interest rather than reducing the principal balance.

Commonly known as the avalanche method, focusing on paying off high-interest debt first offers several benefits. While continuing to make minimum monthly payments on all your credit cards and loans, every additional penny should be directed towards the debt with the highest interest rate. If you require guidance, you can explore a five-step approach to expedite your debt repayment process.

While prioritizing high-interest debt is a wise strategy, it may not be the optimal choice for everyone. If you are already making monthly payments towards multiple debts, you might have limited additional funds to allocate towards your highest-interest debt. Furthermore, if you are faced with a substantial debt, the avalanche method may seem discouraging as the task of paying it off might appear insurmountable.

For Instance:

Let’s consider the scenario where you have the following outstanding debts:

Debt 1: Credit card with a balance of $500 and an Annual Percentage Rate (APR) of 20 percent.

Debt 2: Credit card with a balance of $1,000 and an APR of 21 percent.

Debt 3: Auto loan with a balance of $20,000 and an APR of 8 percent.

Debt 4: Personal loan with a balance of $5,000 and an APR of 12 percent.

Debt 5: Student loan with a balance of $12,000 and an APR of 7 percent.

In this repayment strategy, you will make minimum monthly payments on all of your accounts. However, any additional funds left over at the end of the month will be directed towards credit card #2 since it carries the highest interest rate. Once credit card #2 is paid off, you will continue this pattern by focusing on credit card #1. Subsequently, you will prioritize the personal loan. This cycle will be repeated until all the outstanding balances are fully paid off.

Pay off the smallest debt first

Advantages: The debt snowball method offers key advantages such as building motivation and fostering commitment to the debt repayment plan.

Drawbacks: However, it’s important to note that this approach may take longer to achieve complete debt freedom, and it could result in paying more in overall interest.

Ideal for: Individuals who struggle with maintaining motivation while paying off their debts.

While some individuals opt to prioritize their debts based on interest rates, others choose to begin by paying off their smallest debt first and gradually progress towards larger debts. This debt repayment strategy, famously advocated by financial expert Dave Ramsey, is commonly referred to as the debt snowball method. The name “snowball” signifies that the approach starts with smaller debts and gains momentum over time.

The debt snowball method proves effective because successfully paying off a debt in its entirety serves as a motivating factor, encouraging individuals to persevere towards their ultimate goal. As smaller debts are eliminated, more funds become available to allocate towards larger debts.

It is worth mentioning that following the debt snowball method may result in paying more in interest compared to prioritizing the highest-interest debt first. However, the psychological benefits derived from promptly paying off smaller debts can be highly rewarding.

To initiate your debt snowball, compile a comprehensive list of all your current debts, arranged in ascending order based on their outstanding balances. While continuing to make minimum monthly payments on all your debts, allocate any additional available funds towards the smallest debt. Once that debt is fully repaid, redirect the extra money towards the subsequent smallest debt, and continue this process sequentially.

For Instance: 

Based on the previously mentioned figures, begin by prioritizing credit card #1 due to its lower balance. Once you have successfully paid off credit card #1, proceed to tackle credit card #2, followed by the personal loan.

Pay debts that most affect your credit score

Advantages: Prioritizing your credit score provides several key benefits, including increased opportunities to qualify for lower Annual Percentage Rates (APRs) and potential increases in spending limits.

Drawbacks: However, focusing on improving your credit score may require lifestyle adjustments, which can potentially undermine your motivation.

Ideal for: Individuals seeking to secure financing for significant purchases, such as a home or a vehicle.

Your credit score serves as a crucial metric for lenders to assess your financial management skills. It is influenced by factors such as the amount of debt you carry, the utilization of your available credit lines, and your payment history.

To maintain a favorable credit score, it is advisable to keep your credit utilization below 30 percent, ensuring that your accounts remain in good standing without any payment delinquencies. Mortgage loan officers and other lenders scrutinize these factors when evaluating your eligibility for a loan.

A strong credit score positions you as a less risky borrower in the eyes of banks and financial institutions. However, prioritizing your credit score may necessitate making certain lifestyle changes to effectively reduce your debt load.

Implementing new habits can present significant challenges, and you may find it necessary to curtail smaller expenses in order to prioritize debt repayment. As a significant portion of your income is allocated towards debt, it is understandable that your motivation may wane. Nonetheless, sacrificing certain comforts can expedite your debt reduction journey and concurrently improve your credit score.

For Instance

Let’s consider the following credit card and loan balances:

Credit card #1: $750 (with a credit limit of $1,000, resulting in a 75% credit utilization ratio)

Credit card #2: $1,500 (with a credit limit of $3,000, resulting in a 50% credit utilization ratio)

Credit card #3: $250 (with a credit limit of $2,500, resulting in a 10% credit utilization ratio)

Auto loan: $25,000

Student loan: $15,500

Given that your credit utilization plays a significant role in determining your credit score, it is crucial to prioritize paying down credit cards with high utilization rates. Begin by focusing on the credit cards that have utilization rates exceeding 30 percent. By reducing the utilization on these cards, you will have the greatest opportunity to enhance your credit score, while also ensuring that your other bills are paid on time.

Use a balanced method

Advantages: One of the key advantages of this approach is the flexibility it offers, allowing you to tailor your debt repayment plan according to your individual circumstances. In case of an emergency, you can manage unexpected expenses without compromising your goal of becoming debt-free.

Drawbacks: However, without a clear and structured strategy, there is a risk of losing motivation and potentially derailing your debt repayment progress.

Ideal for: Individuals who require a certain level of flexibility in their debt repayment journey while still maintaining motivation.

Confronting a significant amount of debt can seem overwhelming, particularly when tackling the largest debt first. In certain situations, smaller debts can be deferred to prioritize more pressing circumstances, such as debts that have entered collections. Additionally, debts that offer tax deductions for the interest paid, like student loans or home equity loans used for home improvements, may take a lower priority.

So, what can be done in such scenarios? The key lies in adopting a balanced approach that is uniquely tailored to your specific needs. You have the freedom to incorporate any of the three debt repayment options in the order that best suits your circumstances. For example, you may choose to address a debt in collections before focusing on paying down your credit card balance, while continuing to make minimum payments on your other accounts during this time.

For Instance

Based on the previously mentioned figures, there are several approaches you can take to initiate your debt repayment plan. One option is to begin by focusing on paying off credit card #3, as it has the smallest balance. Alternatively, you could prioritize the debt with the highest monthly payment or interest and gradually work your way down. Another strategy involves dividing any surplus funds you have each month and allocating a small additional amount to each debt.

Ultimately, the key is to develop a sustainable strategy that ensures you maintain momentum throughout the entire payoff process. By finding an approach that aligns with your financial situation and preferences, you can establish a solid foundation for successfully reducing your debt and achieving your goal of becoming debt-free.

Consolidate your debt

Advantages: Consolidating your debt into a single monthly payment can provide several key advantages. Firstly, you may be eligible for a lower interest rate, which can potentially save you money in the long run. Additionally, consolidating your debts simplifies your finances by having only one payment to manage. This can make budgeting and tracking your progress easier. Moreover, by streamlining your debts, you can focus on repaying them faster and potentially become debt-free sooner.

Drawbacks: It’s important to consider the drawbacks of debt consolidation. One potential drawback is the possibility of up-front costs associated with the consolidation process, such as balance transfer fees or loan origination fees. Additionally, there is a chance that you may not qualify for a lower interest rate, especially if your credit score is not favorable or if your financial situation is deemed risky by lenders.

Ideal for: Debt consolidation is particularly beneficial for individuals who make multiple monthly payments with high annual percentage rates (APRs). If you find yourself juggling various debts with high-interest rates, consolidating them into a single payment with a potentially lower interest rate can provide significant financial relief.

There are a few options available to consolidate your debt into a single monthly payment. One option is to transfer your existing credit card balances to a balance transfer credit card. Leading balance transfer credit cards offer promotional periods of 15 to 21 months with 0 percent APR on balance transfers. This allows you ample time to begin paying off your debt without accruing interest on the transferred balance.

Another option is to obtain a personal loan and utilize the funds to pay off high-interest debt. If you can secure a personal loan with considerably lower interest rates compared to what you are currently paying, you have the potential to reduce the overall cost of your debts. Utilizing a debt consolidation calculator can help you determine the potential savings you could achieve by opting for a personal loan.

Lastly, you may consider consolidating your debts through a home equity loan or a home equity line of credit (HELOC). To assess whether tapping into your home’s equity to pay off your debts is a viable option, utilize a home equity calculator. It’s important to exercise caution when using your home as collateral. Falling behind on mortgage payments puts you at risk of foreclosure, so careful consideration is necessary before opting for a second mortgage to pay off unsecured debts.

Summing Up

When it comes to paying off your debts, you have a variety of methods to choose from. You have the flexibility to combine different strategies and create a customized plan that aligns with your specific needs and keeps you motivated throughout the process. However, it’s important to ensure that the plan you select is realistic and achievable for you. Take the time to write down your plan and make a commitment to stick with it until you successfully reach your financial goals.